Why The Euro Is So Strong, Or Why The Market Expects $700bn Of Fed QE3

The question puzzling currency markets is why the EUR is so strong. While we have argued that during the risk-off period of the last month or so post-LTRO2 (before Tuesday) EURUSD strength appeared to be driven by repatriation flows and balance sheet reduction, new information over the last couple of weeks driving the expectation that growth will be weak enough in the US to keep US policy very stimulative for a nice long time, we tend to agree with Steven Englander of Citigroup who argues that it looks very much as if QE3/Fed-stimulus anticipations are behind the EUR relative strength recently. Indeed the recent USD weakness is pretty much across the board, suggesting that it is less EUR attractiveness than USD unattractiveness that is driving the EUR’s gains. That said, I think the buzz around various euro zone measures to help out banks and ease the rigidities of the fiscal compact is also helping support the EUR by reducing tail risk, but right now the USD/Fed is the bigger story. Back of the envelope math based on the Fed/ECB balance sheets and EURUSD implies the market expects around $700bn of QE3 and given swap-spread differentials there appears to be little liquidity premium to reduce this expectation.

The current EURUSD rate implies a Fed/ECB ratio of around 1.2x which infers that the market expects around $700bn of liquidity from the Fed relative to the ECB in the short-run...

And there is little additional liquidity premium (over interest rate differential models) as swap-spreads and EURUSD begin to correlated more highly and also with risk...

Consider first the evidence that the EUR is positively correlated with risk (Figure 1).

The chart above presents the euro’s beta on changes in other measures of risk appetite. The chart is scaled so that a positive value shows a risk-positive correlated and we use two-day changes to mitigate the impact of different closing times in different markets. What it shows is that the underlying correlation of the euro with risk is positive. It is not clear why this is the case, although I would argue that a risk-positive environment makes investors more willing to tolerate tail risk than a risk off environment and the reserves accumulation/diversification cycle probably is more intense when risk is on. Investors may be wrong in trading the EUR with a positive risk correlation but it is hard to argue that they do not do so.

Now consider the charts below. In each case the blue line represents the S&P, the yellow line US two year yields and the green line EUR. What we see are episodes in March/April; 2009 and Aug/Sep 2010 when US 2 year yields fell and the S&P rallied. Presumably these are period when growth was disappointing (i.e. investors drop their expectations of policy rate hikes) but equity markets and the EUR rally because the low rates support valuations even in a low top-line growth environment. As a colleague expressed it, even a tiny stream of returns is worth a lot when the discount factor is close to zero. So we have a series of episodes in which risk is bid, and the euro with it, despite economic disappointment.

Now consider Figure 4 which shows the most recent moves in 2yr yields,the S&P and the EUR. We see a similar pattern – 2yr yields drifting down and the S&P and EUR running up. The scale of the rallies is not as big as in the other episodes but the family resemblance is there. For the USD risk-on is a negative and low rates are a negative, and that is what the market is focused on.

Now consider Figure 5 below which presents the EUR, the S&P and 2yr Treasury yields from 2009 to the present (hard as it is to believe that 2yr Treasuries were yielding 0.80% just over a year ago). The big picture is that the recovery has disappointed everyone except investors. Going back to 2009 and even early 2011, the fixed income market thought there was an imminent recovery that would enable the Fed to tighten – since mid-2011 that expectation has disappeared. The trend in equity prices suggests that there has been a stream of surprises either top-line on expected profits, or in terms of the rate used to discount this stream of returns. The low discount factor to be applied to the expected stream of profits may have been especially important over the last couple of quarters when profit growth has eased.

Bottom line for the last three years is that risk appetite can be positive on the whole, even with disappointing economic performance and this positive risk appetite and asset market environment supports the euro. From Figure 4 it is clear that the degree to which the EUR is positively correlated with risk diminished in H2 2011 when the sovereign debt crisis spread to Italy and Spain. However, no correlation that we run with respect to any indicator of risk (US S&P, EM MSCI, VIXC etc)shows a negative correlation of the euro and risk – the correlations show a diminished but still positive beta (back to Figure 1) and this is true whether the correlations are over shorter or longer spans.

Putting this together we have a currency that is risk positive through tail risk shrinkage when risk appetite is strong and a Fed that supports asset markets via low rates, despite disappointing economic asset market performance. It adds up to a weak euro when risk is off and investors do not yet anticipate a policy response and a stronger euro when the policy response arrives (carrying with it extremely unattractive yields in US asset markets).

What can go wrong? It seems to me that the market bias to buying EUR in periods of risk appetite can easily disappear if it looks as if European policymakers have lost control over the euro crisis. I would stress that recent experience suggests that investors do not care much how the euro zone deals with the tail risk as long as they find a mechanism for doing so. If not the euro and the euro zone could easily fall. It is also the case that if the euro situation becomes sufficiently dire, there will be a negative global impact both on activity and risk appetite. Our betas may not change but we can have positive betas as asset markets collapse, as easily as when they rise. To be sure the Fed has not announced, let alone implemented, an additional easing round so it is possible that the new found positive asset market environment will fade, taking the euro down with it.

Net, net I would argue that the new information over the last couple of weeks is the expectation that growth will be weak enough in the US to keep US policy very stimulative for a nice long time. Whether you like it or not, the euro remains sufficiently correlated with risk for this to be a plus.

As a footnote, earlier this week, I presented some evidence that in H2 2012, balancing sheet cutting and repatriation of foreign assets may have also helped the euro. The two explanations are not necessarily inconsistent, but I would argue that in a positive risk environment the dominant factor would be investors risk appetite, provided that the sovereign debt crisis was not in an acute stage.

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Nobody in the media is talking about it, but the most important number today was 2.1% core PCE (personal consumption expenditures price index — Bernanke’s favorite measure of inflation). It is finally above 2% (spiked up from 1.9% to 2.1%). There is no way Bernanke can do QE-3 when core PCE is above 2% (QE3 is dead).

Was thinking the same with that CPE. There's just nowhere for the money to go right now. The 10 yr. already has negative real rates. I guess there can be a sharp sell off in stocks and commodities to drive bond yields even lower, but how much more negative can real rates get? Seems like the market's at a magic point in which money won't flow into bonds any more, so it has to flow into commodities and equities which will drive the inflation train and the inflation train will drives yields higher as investors get tired of deeply negative real rates of interest. Higher yields just means more printing, which means inflation.

I think we just experienced the calm before the storm. The calm is ending.

Yes, but during the conference on Wednesday, Bernanke explicitly said that “multiple studies have shown” that when inflation is above 2%, there is little if any benefit from QE to help the unemployment (Bernanke was answering a question from a media bonehead crying and whining about Bernanke not using unemployment above 8% as an excuse to print and help to re-elect Obama).

Even Bill Gross (who usually gets insider information directly from the Fed) said yesterday on Bloomberg TV that he is no longer betting on QE3.

When Gross shorted the treasuries, everyone (including the Fed) was talking about an "exit strategy". He got the correct information from the Fed (via Greenspan who is nowadays employed by Gross – Gross actually signs Greenspan’s checks), but then even the Fed (not only Gross) was surprised and forced 180 degrees to abandon the exit strategy.

The Fed can't allow rates to go up as it is leveraged at over 50 to 1. Imagine the effect on the Fed if rates double from where they are now (0.5% isn't a lot but it's a doubling of 0.25%!).

I keep saying this but if Bernanke can keep the markets up just by jawboning or hinting at QE, he won't do it. He'll only do it when he HAS to, which will require another sharp stock market sell-off.

I've been thinking that this will occur after the Facebook IPO in May - I don't think it can be keep going until the election although I could be wrong (I was expecting a sell-off after the poor GDP yesterday but the market went UP!).

The Fed can't go bankrupt no matter how leveraged they are. They don't have accounting, they don't need to make profits, and they can create as much money as they want.

I agree with everything else you said, but I think that rate rises effect the government's ability to borrow (and pay back) from other countries - which is less inflationary than printing the borrowed money into existence.

The incredible thing is that the stock market used to mostly rise without the Fed's help. One can argue that it has been trying to "help" get the stock market to keep going up for the last decade. The results have been less than impressive.

And over 10 years, the market is down horribly working in inflation. Not a positive thing when a pension needs a 7% increase every year at minimum to continue basic growth and liability counters.

I'm reading this morning that the teacher pension funds are short in Nova Scotia by a couple billion dollars and they haven't begun to finish the audit. I'm curious to know what the situation with the world's largest investment group the Ontario Teachers Union is. A year ago, everything was fine in NS, this year somehow money vanished.

Can't wait to see what the Army pensions, the NSA pensions, CIA pensions, FBI pensions. The same people helping enforcing the current mess are more than likely paying for it in spades with their pensions and don't even know it. The teachers didn't until checks started bouncing and someone was forced to take a look.

Funny thing about crooks running things is they don't discriminate against who they steal from. The economy of scale thing works in there as well. All these pensions are all similar in terms of investment practices from department to department. It's impossible to pay peter to pay paul because it's all fungible. It's a big pool of loot, so if your neighbour is short on the till cash out, it's a sure thing so are you. In terms of investors. The teachers unions are a force of nature, they do not get fucked with, ever. It appears that is no longer the case though.

What chance do the tiny pension plans like the US Army, FBI, NSA, DHS or CIA..or any of them have?

None, none at all. Bet a beer they are nearly empty and rolling out the last of the nickles left in them.

You would need some major market selloff (~20%) or outright negative GDP numbers for Bernanke to justify QE3 now.

As far as EUR/USD, the most likely explanation is PBOC buying EUR to stimulate Chinese economy (higher EUR, more Chinese junk exports). Many are forgetting that RMB is pegged to USD (not to EUR); so Chinese can make their currency weaker and increase exports by knocking down USD (knocking down RMB) and propping up EUR.

@Cult: There is a way...It's called Biflation aka killing the buying power of your income and net worth.

Biflation provides camouflage for both killer inflation and deflation. It's brilliant! At every turn Ben can point to the numbers and tell us that everything is tepid, even Goldilocks -like. It's the moderation's moderation: keep pushing real household incomes and net worth down plus economic activity and you can hide even double-digit inflation

As long as both forces are at work all the numbers will cancel to near-zero. And depressed economic activity keeps a brake on prices just as prices keep a brake on economic acitivty. A thing of beauty.

@docj: well put. It's a strategy to accelerate the transfer of wealth to China and elsewhere. I saw several reports this week about US multinationals adding 3X as many jobs abroad. Apple's report confirms that China is the olny engine of corporate growth (cudos, Tyler). And you can bet banks have their fat little fingers in the pie. Call it planned-obsolescence for an entire country.

Thirty-five big U.S.-based multinational companies added jobs much faster than other U.S. employers in the past two years, but nearly three-fourths of those jobs were overseas, according to a Wall Street Journal analysis........Nearly 60% of the revenue growth between 2009 and 2011 at the companies in the Journal's analysis came from outside the U.S.

"If it happens in politics you can bet that it did not happen by accident".

John Maynard Keynes:

"By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some. The process engages all of the hidden forces of economic law on the side of destruction, and does it in a manner that not one man in a million can diagnose."

Yes, effects are being exacerbated, exactly my point. Buying power of consumers is getting crushed by combined decrease in real median incomes and household net worth (as mainly impacted by perpetually declining real estate values). And yet simultaneously there is increase not just in the price of necessities (energy, food, transportation, telecomunication) but in the cost of home ownership (insurance, taxes, upkeep and maintenance, improvements, ultilities, muni services, security etc). Whammy and double whammy.

Stagflation was a term invented in the late 1970s to describe the situation that existed back then which is very different than now. I was at Wharton back then and was privy to all the discussions. Basically, the inflation of the 1970s was mainly caused by what was called "the wage spiral" INcomes were rising sharply and that that was viewed as causing "demand-pull inflation". Also house prices were rising sharply as a result but also because boomers were in peak family-building mode. Also raw materials and transport were comparatively cheap inputs at that time.

There was no deflation of any kind during the 1970s. Offshoring and outsourcing of industries and jobs had barely begun after Nixon's China deal (1971-2). There was no where near the level of overcapacity we see today. There was no where near the level of depressed labor force participation. There was also no huge credit bubble and Glass-Steagle was still in full force so there was no near-death banking sector bust pulling down all financial sub-sectors.

The results are and will continue to speak for themselves. During the 1980s there was a strong attempt to stp the growth of wages and incomes. And it has been successful as real median income has hardly grown in over 30 years. This is more than a middle class squeeze. This is the death spiral of the middle combined with what I call the Downsizing of America

Caviar Emptor
Many thanks for your reply, fascinating and interesting.

And yes, I agree completely with your last paragraph, true here in Europe and the UK as well.

And we're either being ruled by public school educated career politician ninnies with no real world experience AT ALL (Cameron of the Conservatives, Clegg of the Liberal Democrats and Milliband for Labour) or the mainly ex-Goldman technocrats like Draghi et al.

Except nobody really wants a weaker currency. They just want an excuse to create money. What better excuse than "We're printing this money and handing it out to whom we deem worthy" than for the good of the exporters?

The truth is that efforts should revolve around the consumer. There's no other reason to produce than to consume and there's no other reason to export than to import something else in return. The more goods at cheaper price available to the consumer, the better.

You have mistaken Ben Bernanke to be a rational, consistent, non-psychopathic human being and QE3 to be a choice constrained by reality or consequences. Ben will do whatever it takes and QE or the threat of it is Ben's favorite tool.

Nobody in the media is talking about it, but the most important number today was 2.1% core PCE (personal consumption expenditures price index — Bernanke’s favorite measure of inflation). It is finally above 2% (spiked up from 1.9% to 2.1%). There is no way Bernanke can do QE-3 when core PCE is above 2% (QE3 is dead).

And directly related to that is the most important second derivative of PCE...

...GASOLINE PRICES.

Obama can't get re-elected if they lose control of it. $5+ a gallon gasoline will insure he's a one-term wonder.

IMO this argues strongly AGAINST MORE (immediate) QE... But WTF do I know...

Obama can't get re-elected if they lose control of it. $5+ a gallon gasoline will insure he's a one-term wonder.

I can't take this gasoline price argument anymore. To think that is the impediment to more QE is insane. First off the media will spin it as Iran's fault and most people will be sympathetic to that. Secondly if gasoline prices got out of hand they would look to Bernak to fix it. Is it backwards retarded? Yes. But thats how it goes.

HOW is The Bernank gonna fix it? CTRL-P will only make the $ of gasoline shoot higher!

Simple, actually. The federal government will blame speculators and Iranian tensions for the increase in fuel prices, and then impose PRICE CONTROLS on fuel. From Obama's perspective, this would "solve" the problem of higher fuel prices.

Bernanke will say anything to talk himself out of a situation. He might do it anyway regardless of inflation. You make the mistake of thinking that the fed and bernanke are actually honest and consistent.

"Secret talks between 200 Arab billionaires in Abu Dhabi, UAE took place during Easter weekend in April 2010 to discuss the death of the petrodollar and the realignment of military protection of MiddleEast oil fields, according to a source close to Jim Willie of the Hat Trick Letter"